Milton Friedman is the worst possible taste at present

By Alex Millmow

30 January 2009 — 12:00am

THESE are sad times for the Chicago School of Economics, which gave the world such creeds as monetarism, human capital theory, rational expectations and the now-infamous efficient market hypothesis. The school has won seven Nobel prizes in economic science since 1972.

Just last October, another Chicago economist, Eugene Rama, was a hot tip for the prize for his work on efficient markets, before the selection committee, with the financial markets having gone berserk, thought better of it.

Now an acolyte of the Chicago school, Sir Alan Walters, Margaret Thatcher's personal economic adviser in the 1980s, has died.

A little like the grocer's daughter Thatcher was, Walters, too, came from humble stock and rose to become one of Britain's top economists. He was the man who brought monetarism to Britain.

When Britain was unable to cope with the 1970s stagflation crisis, it was Walters who advised Thatcher to ditch the Keynesian consensus and opt for a blatantly deflationary budget. Even Thatcher took some persuading. She wrote in her diary in April 1981: "The budget he was arguing for would be unpopular with the public, mystifying to many of my strongest supporters in the Conservative Party and the country, and incomprehensible to those economists still stuck in the postwar Keynesian orthodoxy."

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Walters' prescription was to take £5 billion out of the British economy by raising taxes while in the middle of a recession. One result was 364 British economists indignantly writing an open letter to The Times stating that the policies were wrong-headed. Thatcher withstood them. It was the Falklands War of 1982, though, that saved her political skin.

Walters' passing is somewhat poetic, with monetarism and neoliberalism on the wane and Keynesianism resurgent. It has got so bad that a proposed research institute at the University of Chicago dedicated to the founding father of modern monetarism, Milton Friedman, has raised a storm of controversy because academics there objected to Friedman's ideological line. It used to be the case that Friedman's name was synonymous with the University of Chicago; not any more. When the institute's charter was originally proposed in May 2008, 100 Chicago professors saw it as a wholesale endorsement of Friedman's free-market ideology, especially the clause "that the design of public policy without regard to market alternatives would have adverse social consequences".

One professor, Bruce Lincoln, summed it up: "Friedman's over the current crisis dramatises the limitations of his position. His time was important, but it's past."

The institute will now be known as the Milton Friedman Institute for Research in Economics and it will be value-neutral, with the focus on academic research rather than upholding the legacy of one man.

There are challenges afoot, too, to Friedman's intellectual legacy.

His explanation for the Great Depression contained in A Monetary History of the United States famously pinned the blame on the Federal Reserve for stopping bank failures and not increasing the money supply. It was in this context that Bernard Bernanke of the Federal Reserve lauded Friedman a few years before his death with the comment: "You're right, we did it. We're very sorry. But thanks to you, we won't do it again." Bernanke may have to eat his words. It is now plain to all that monetary stimulation by itself will not work without fiscal policy or government spending leading the way.

Another Chicago economist and Nobel Prize winner, Robert Lucas, was as late as August dismissive of the idea that the subprime problem would develop into a full-scale economic crisis. In 2003 he told the American Economic Association that the central problem of stabilising market economies had been solved and it was time to move on to other areas of research.

Earlier in his career Lucas had argued that the mass unemployment of the Depression was attributable to the fact that a third of the American workforce walked away from their jobs en masse because they figured that the wages they were being paid did not compensate for the disutility of work. In other words, it was all simply a labour-leisure trade-off!

It's remarkable that such views are taken seriously, but they are.

It is hard to contemplate just how conservative the American economic profession really is.

A recent poll found that half of American economists believe that Roosevelt's New Deal policies of fiscal stimulus  such as those President Obama will have to contemplate  did not help America get out of depression but rather lengthened and deepened it!

They are prone to see the government as the problem, not the solution. When they do adopt Keynes, it is a Krispy Kreme version of him  all sugar-coated and fluffy  rather than the one that allows insight into the uncertainties and perverse "animal spirits" that can befoul a monetary economy. Keynes knew that financial markets could disintegrate and quickly undermine confidence in the economy. This is where Britain and America are now.

In the 1960s president Kennedy had to deal with recalcitrant military brass over confronting the Soviet Union; Obama will have it with recalcitrant economists fighting the last doctrinal war in economics.

Alex Millmow is a senior lecturer in economics at the University of Ballarat.